When exactly (time) is the 'automatic exercising' of an option triggered?

Question

I understand that - for many brokers - an option that runs out is automatically exercised when it is 'in the money' on the end of its last day.

My question is at what exact time is the decision made? (based on which closing price?)

Current example: today, 2020-09-11, I have shorted puts for LUV with a strike of 39 that end today. At market close, which is 16:00 (4pm), they are in the money (LUV closed at 38.95). In after-hours trading, LUV went back over the strike price (and that might change again, as the day is not yet over, ignore that). Let's assume it closes at 20:00 (8 pm) at 39.05.

There are very different outcomes depending on the time when the exercising decision is made:

• at 16:00 - that means the option is automatically exercised, and someone out there sells me a truck full of LUV for 39.00. I turn around and sell them on the market for maybe 39.05. He probably is not happy with that (assuming he didn't react in time and stop the execution)
• at 20:00 - that means the option decays worthless.

The question is - do brokers use the 16:00 market close price, or the 20:00 after-market close price for the exercising decision? - and, when will the exercised LUV shares appear in my account, so I can sell them?

Answer 1

Just to clarify, options are automatically exercised if they expire a penny or more in-the-money.

This is a policy or rule set by the Options Clearing Corporation (that clears all US exchange listed options).

The price used is the official closing price of the security, which is the closing price published by the primary exchange (the one responsible for maintaining the listing of the stock) at the 4PM close (note: some indices close at 4:15 PM).

The policy does not prevent the holder of the option submitting an exercise instruction anyway (i.e. I still want to buy the stock at the (call) option strike price, regardless of whether the option expired in the money), nor submitting a contrary exercise instruction (I.e. I do not want to buy the stock at the (call) option strike price, even if it expired in the money).

Brokers have until around 5:30 Eastern (4:30 Central) to submit exercise or contrary exercise instructions to the OCC (it depends on the rules of the relevant options exchange). In turn the deadline for the brokers' customers may be earlier and will vary from broker to broker.

OCC page on Options Exercise

If for example your broker allowed you to submit an exercise instruction until 4:30 PM, and the price was out of the money at the close, but in the money after the close, you could submit an exercise instruction at 4:29 (assuming you get it in by the 4:30 deadline), as it would not be automatically exercised as the option was not in the money based on the closing price.

Answer 2

Brokers have in house rules for who gets assigned prior to expiration but they are not involved in the auto exercise decision for ITM options at expiration.

In the US, if an option is one cent or more in-the-money (ITM) at expiration, the Option Clearing Corp (OCC) will automatically exercise options whether they are long or short. This is called Exercise by Exception.

If you are long the option, you can designate to the OCC via your broker that it is not auto exercised at expiration. This would make sense if it is ITM by pennies and your commission and/or fees to close the position exceeds the ITM amount. Short sellers have no such ability.

There's a lot of contradictory information out there about when expiration is.

Per Investopedia:

Typically, the last day to trade an option is the third Friday of the expiration month, but the actual expiration time is not until the next day (Saturday).

The NASDAQ offers a more detailed definition: "The expiration time is the time of day by which all exercise notices must be received on the expiration date. Technically, the expiration time is currently 11:59 am Eastern time on the expiration date, but public holders of option contracts must indicate their desire to exercise no later than 5:30 pm on the business day which precedes the expiration date."

A public holder of an option usually must declare their notice to exercise by 5:00 p.m. (or 5:30 p.m. according to NASDAQ) on Friday.

The above is for equity assumptions and assumes that the market is open on Friday. Also note that the expiration time may be 5 PM or 5:30 PM. Even Investopedia doesn't provide a clear answer. To add insult to injury, some web sites state that this is for standard monthly options but don't spell it out for weekly options.

What I can tell you is that it is good practice to buy to close all options that are at-the-money at expiration (or designate non exercise to OCC for long options) if you don't want a possible position in the underlying. The OCC handles the exercises and assignments over the weekend and you can wake up Monday morning with a long or short position in the underlying with unexpected and significantly large directional risk.

This problem is called Pin Risk. You can read about it here.